Value Model With Many Economies Term Paper

  • Length: 21 pages
  • Subject: Urban Studies
  • Type: Term Paper
  • Paper: #46637784

Excerpt from Term Paper :

462). It is small wonder that some insurance companies understand the risks of insuring lives and the accompanying cash surrender values of a life insurance policy.

In a prime example of how some insurance companies were caught up in the evaluation game is the case of AIG, the company that forgot that the value of its stock, or the value of the company was based primarily on a fair value, that might not have been fair at all. The harbinger of disaster was when the financial marketplace placed a fair value on AIG that was far below what the company believed it should be. This scarcity could be one of the primary reasons why the financial industries around the world are in the torrents they are currently swimming.

Some of the literature available touched on the primary causes of the current financial crisis before it took place. One recent study reiterated the conclusions of other studies by stating, "many previous studies identify loan, property, borrower and environmental factors that impact the probability of foreclosure" (Ong, Neo, Spieler, 2006, pg. 212). The article continued with a prophetic statement, "implicit in these studies is the assumption that the property was purchased at fair value" (Ong, et al., pg. 212). As the investors watched skyrocketing values on not only the mortgage derivatives but on the underlying properties, more and more individuals, companies and entities came to the conclusion that the prices would go up forever. After all, the fair value was what any two parties decided it would be, and with Wall Street and other exchanges rushing to bring more of these sub-prime investment vehicles to market, and the banks being even more willing to loan to anyone who could sign their name, it seemed as if real estate would only be more and more profitable.

The study conducted by Ong et al. rang a warning bell. Their research showed "we find that the premium paid at purchase significantly increases the probability of foreclosure" (Ong, et al., pg. 213). The researchers concluded that the results of the study were not dependent on "other property-specific factors, time-varying macroeconomic conditions, alternative model specifications and definitions of price premium" (Ong, et al., pg. 213).

In essence, the Ong study showed that a primary factor in the risk of foreclosure was due to the premium paid for the property at the time of purchase. If this finding is true, then one can only imagine what the effects would be in a scenario of ever-increasing fair value valuations.

In the mad rush to ensure a profit for their respective firms, what the financiers and bankers forgot was that an effective market is one that has some form of rationing implemented. Just as the technology bubble was bursting in the early 2000's a study was published that espoused the fact that "economists praise the virtues of price as a mechanism to equate supply and demand, but markets often clear by non-price means" (Gilbert, Klemperer, 2000, pg. 1). The study showed that if the real estate market had continued to hold steady values, or had been subject to a mild form of rationing, much of the pain currently being experienced in the financial industry would likely have not been felt. This is likely because fewer buyers would have been interested in jumping into the market without that added incentive of rising real estate values.

When Congress changed the rules, virtually stating that 'everyone deserves a home of their own' and the banks realized that the government would guarantee the viability of the higher risk loans through Freddie Mac and Fannie Mae, they immediately started making more high-risk loans. Builders responded by building additional and bigger houses. Property owners responded by selling their smaller and medium sized homes, and purchasing the bigger and more expensive homes. and, of course, many exchanges around the world responded by snapping up the high-risk mortgages and packaging them for resale to investors searching for higher returns. If someone had someone taken a deep breath early on in the process, perhaps remembering the HKAS directive that states 'fair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm's length transaction" (HKAS 40, pg. 3) and perhaps realizing that many of these arm's length transactions were not really at arm's length, then this entire mess could have likely been avoided. Another method of measuring the value could have been implemented such as the cost model that would have reminded investors of what the real value of the investment was, not the fair value.

Gilbert and Klemperer concluded "in our main analysis, rationing does not affect the number of consumers who enter (i.e., invest) but does induce them (the consumers) to enter at a lower cost to the seller" (Gilbert, Klemperer, pg. 2). Sometimes it makes sense to lower costs even if the result is a lower value for the property.

Another article on fair value concerns the solvency of a company, in this particular case it is an insurance company. The articles shares a method of defining solvency of a company and the financial impact the lack of solvency has on a company's operations. The reason such information is important is because of the value of the insurer's balance statements. Since many large, and even small, insurance companies maintain real estate portfolios the underpinnings of the solvency or lack thereof for certain companies remains a concern. The articles describes "a method to allocate capital in insurance to lines of business is developed based on an economic definition of solvency and the market value of the insurer balance sheet" (Sherris, 2006, pg. 72). Therefore, it is safe to assume that with the volatility inherent in a fair value evaluation can affect the solvency of companies large and small, especially if the company is holding large portfolios of real estate. The article does not compare insurance companies in Hong Kong, and in fact, does not mention Hong Kong in any form whatsoever. However, it can be inferred that a large percentage of the financial services offered in Hong Kong deal with insurances of one type or the other, and that at least a number of the insurance companies located there currently hold real estate as part of their investment portfolios.

If that assumption is held true, then publicly traded shares of those companies will likely be affected by the use of a fair value valuation, and in all likelihood, the very solvency of some companies can be affected as well.

In the Sherris article can be found the statement "solvency, and its financial impact, is determined by the value of the insolvency exchange option" (Sherris, pg. 72). This reinforces the fact that how an investment or holding is valued can be a determinant in how well a company is managed, or even if the company would be the type of company that would generate profits for its shareholders.

The available literature does take into consideration other areas where the fair value model is implemented along with the use of the cost model. One area that has been covered is data that is produced by companies who wish to either protect the value of that information or protect the information itself (in the event of a loss). Ralph Poore writes for Information Systems Security and he states, "information security professionals are often asked by management to balance the cost of controls, against the value of the information assets that the controls protect" (Poore, 2000, pg. 18). Poore continues by stating, "cost-based valuations (often used to determine a "book" value for intellectual property) also fall short for risk management purposes" (pg. 18). This literature displays the inherent problem with cost-based evaluations. A book value for information as compared to a book value for real estate property or investment property is comparable based on what it costs, but suppose the cost of the item, whether it be data, or whether it be real estate, does not reflect its true value?

At what price, then, should such an investment be valued? The question of placing a 'fair value' on the investment, whether it is insurance, information or physical land holdings, should make no difference whatsoever.

One would think that a fair evaluation agreed upon by all parties would then make the most sense. Poore, however, might disagree. He wrote, "nonetheless, relying on opinion averaging or similar highly subjective techniques rarely results in defensible valuations" (pg. 19). The limited available literature shows that subjective techniques such as the 'fair value' model may, oftentimes, come up short on offering defensible valuations, and in the worst case scenario cause the valuations to spiral upward until they hit a ceiling that quickly forces them back down.

One of the forerunners of the packaged mortgage investment vehicles was the Real Estate Investment Trust (REIT). These investments vehicles were introduced to the public nearly four decades ago…

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